5
I
Prime Custody: Achieving Asset Protection & Operational Simplicity
Issues Emerge with Early Prime Broker
Segregation Offerings
Simply shifting assets outside the prime broker’s control and
off the broker-dealer entity into a special purpose vehicle or a
segregated account at a custodial bank solved for some issues
around asset protection and transparency, but raised others
in turn.
Early “Prime Custody” solutions were set up in one of two
ways to ensure speed to market. Very little advancement has
been made in these models since that time and most of these
solutions remain unchanged since their initial launch.
SPVs:
Some prime brokers created an internal special purpose
vehicle or trust company that segregated excess assets into a
separate account with enhanced bankruptcy protections.
This model provided legal entity separation from the broker-
dealer and allowed fund managers to coordinate their
segregated assets via the same Prime Finance personnel
they already faced off against on a day-to-day basis. However,
this arrangement left segregated assets housed on the same
infrastructure as prime brokerage accounts.
Feedback on these arrangements highlighted concerns among
investors that the segregation of assets was not remote enough
to ensure that they would be fully protected and would be able
to recoup all their assets in an orderly dissolution as part of a
bankruptcy proceeding.
The ability to ensure equal levels of asset protection across
the globe was also cited as a concern. Hedge funds and
investment managers tend to operate in multiple markets and
trade assets across the globe. This requires an ability to operate
in numerous time zones and in many markets with unique and
stringent local requirements.
Special purpose vehicles set up by some prime brokers for
custody failed to take into account the unique bankruptcy
protection laws and regulatory requirements of many markets.
This limited their effectiveness outside select fnancial centers
The SPV Prime Custody model is highlighted in Chart 2.
Third-Party Arrangements:
Other prime brokers created
remote arrangements with third-party custody banks.
Feedback on these arrangements indicated that they satisfed
investors’ need to see the assets moved completely off the
broker-dealer infrastructure, but increased the operational
complexity of managing such assets.
As part of daily operations, teams at the hedge fund or
investment manager would need to directly authorize the
movement of securities into and out of the custody account
or assign those rights to their prime broker through the
negotiation of a “control agreement”.
Control agreements are often unclear on how situations
between the prime broker and the custody bank should be
handled. When disputes arise, the hedge fund’s own operations
team often has to intervene to help fnd an acceptable path
forward. In some instances, assets have reportedly been frozen
pending resolution of such disputes, limiting the ability of the
hedge fund manager to fully utilize these securities.
Beyond uncertainty around the handling of disputes, there
are other aspects of the remote custody model that create
operational concerns. Specifcally, remote third-party custody
arrangements require that the fund’s operations team
monitors the movement of securities between custody and
prime brokerage accounts, ensures that parties meet their
transfer deadlines, monitors international accounts for actual
settlement of positions, and manually instructs and manages
the recall of securities with pending voluntary corporate
actions if the portfolio managers want to utilize those positions
in their trading strategy.
The Third-Party Custody model is highlighted in Chart 3.
Chart 2: Prime Custody via Special
Purpose Vehicle